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2023 marks the last step on the LIBOR transition journey. With June 2023 cessation deadline for USD LIBOR in mind, market participants must not relax their efforts to ensure an orderly transition.
In brief
- The turn of 2023 is an opportunity to review the latest news from the past year on the LIBOR front.
- Momentum must continue in order to avoid a transition traffic jam and successfully transition away from USD LIBOR by end of June 2023.
- Market participants must consider the impact of recent developments and plan for the cessation of other IBORs as well as ongoing reforms to the clearing mandates.
With less than 5 months to go until the last USD LIBOR tenors cease to be published, we have witnessed increased engagement from working groups to accelerate the pace of the USD LIBOR transition. Further, given remaining tough legacy contracts based on USD LIBOR exposure yet to transition in the loan market, we observe focus from regulators on the potential introduction of a synthetic LIBOR rate. During recent months, we also witnessed increased focus from the industry on the cessation of other IBORs. The beginning of this new year 2023 is therefore an excellent opportunity to look back on recent LIBOR transition developments as well as to plan ahead as we enter into the final stretch.
1. USD LIBOR TRANSITION
The launch of SOFR First for Options which took place in June and July 2022 was a key step in propelling a successful transition away from USD LIBOR ahead of its cessation in June 2023. Indeed, the initiative, which included a market-wide fee waiver for SOFR options, accompanied by additional market making incentives, built on the impressive growth already seen in SOFR futures, significantly improving the liquidity for SOFR options. In 2022, average daily volumes and peak open interest for SOFR futures increased by several multiples compared to 2021 while average daily values and peak open interest for SOFR options increased by well-over several thousand multiples year-over-year. This year 2023 has also started strongly, with a single-day record of almost 7.6 million SOFR futures and options traded and record open interest of approximately 35.7 million contracts on January 12th, 2023.
However, we noted slower progress in the syndicated loans market. With the end-June 2023 deadline only 5 months away, it is therefore no surprise that we have seen continued encouragement from industry working groups to transition away from USD LIBOR as soon as possible.
The Alternative Reference Rates Committee’s (ARRC) endorsement of the CME 12-month Term SOFR, complementing the previously endorsed 1-, 3- and 6-month Term SOFR rates, is an example of one of the tools available to support cash market participants in the transition away from USD LIBOR.
The Loan Syndications Trade Association (LSTA) also confirmed that the 12-month rate was endorsed for the syndicated loan space and that both legacy as well as new business loans are in scope for 12-month Term SOFR. On the legacy side, the 12-month Term SOFR is a useful tool, particularly for multi-lender facilities, middle market loans, and trade finance loans, where the transition from LIBOR to an overnight rate has been difficult.
However, the ARRC continue stressing the risks associated with any widespread usage of Term SOFR outside of the limited and targeted recommendations suggested by the ARRC as best practice, which have been carefully calibrated to ensure the robustness and sustainability of the rate itself and to avoid risks to financial stability. It strongly encourages market participants to limit the usage of Term SOFR in derivatives and most other cash markets.
In 2022, the ARRC also published its LIBOR Legacy Playbook, a guide describing the existing broad frameworks to support the transition of legacy LIBOR cash products. The guide, including a compilation of best practice recommendations and reference materials, is another tool that can be added to market participant’s toolbox to ensure that the transition from LIBOR is operationally successful.
Nevertheless, as LSTA have highlighted, intended transition plans might actually conflict with market realities. Indeed, LSTA noted in an article issued in October 2022 that 43% of lenders said that the transition will occur by LIBOR cessation on June 30th, 2023.
USD LIBOR cessation
Of lenders answered that most loans will fall back after USD LIBOR cessation date, raising the potential possibility of a remediation traffic jam in the final moths prior to LIBOR cessation.
2. SYNTHETIC LIBOR
Recognising possible tough legacy issues, the Federal Reserve Board adopted on December 16th, 2022, a final rule that implements the LIBOR Act (legislation previously passed in March 2022 aiming to establish a clear and uniform nationwide solution for replacing LIBOR in tough legacy contracts) by identifying benchmark rates based on SOFR that will replace LIBOR in certain financial contracts after June 30th, 2023. As required by the law, the final rule identifies replacement benchmark rates based on SOFR to replace overnight, one-month, three-month, six-month, and 12-month USD LIBOR in contracts subject to the Act. The aim is to ensure that that LIBOR contracts will not be interrupted or terminated following LIBOR's replacement. However, the applicability is still limited.
In 2022, the UK Financial Conduct Authority (FCA) published a consultation to gather feedback on the winding down of GBP synthetic LIBOR and whether, going forward, a synthetic USD LIBOR rate might be appropriate for certain contracts not within the scope of LIBOR-related federal legislation.
Based on the industry feedback, the FCA has announced its decision on cessation of 1- and 6-month synthetic GBP LIBOR at end-March 2023. Publication of 1- and 6-month synthetic GBP LIBOR will be required until end-March 2023, after which these settings will permanently cease. Given that the 3-month setting is its most widely used setting, it would not be unexpected following final review from the FCA, that the 3-month synthetic GBP LIBOR setting would be further extended. However, market participants should be reminded that like for other synthetic LIBOR, users of the remaining tenors of the synthetic GBP LIBOR should continue to focus on active transition wherever possible, rather than relying on a synthetic rate which will not be published indefinitely.
Further, the FCA launched a consultation proposing to compel the publication of 1-month, 3-month and 6-month US dollar LIBOR on a synthetic basis until the end of September 2024. Nevertheless, even if a synthetic is published, market participants should increase their effort and not rely on that said rate.
3. CESSATION OF OTHER IBORS
Over the past months we have continued to witness increased focus from the industry on the transition of other IBORs.
Notably, Refinitiv discontinued CDOR’s publication after June 28th, 2022, following public consultation based on the White Paper recommendation published by the Canadian Alternative Reference Rate working group (CARR).
Following the announcement of the cessation of CDOR, CARR launched a consultation on a potential new term interest rate (i.e., Term CORRA) to replace CDOR in certain financial instruments, notably loan agreements and hedging agreements. Indeed, the demand for a term rate option in CAD loans facilities has been strengthened by the increasing use of Term SOFR in USD loans. Given that many larger Canadian borrowers have a multi-currency borrowing option in their loan facilities, with at least option to draw in either CAD or USD, they would prefer to have a term rate available in both currencies. Further, to ensure a robust term CORRA with sufficient liquidity, the CARR proposes in its consultation to limit the published tenors, at least initially, to only the key 1- and 3-month tenors used currently for lending.
Going forward, Term CORRA would be a useful tool for use in the loan market.
On November 14th, 2022, ICE Benchmark Administration (IBA) published a feedback statement on its intention to cease the publication of ICE Swap Rate settings based on USD LIBOR on June 30th 2023. Users of the USD LIBOR ICE Swap Rate benchmark should take account of its upcoming cessation and ensure their contractual and other arrangements linked to the benchmark contain appropriate fallback or other arrangements to address the cessation.
Further, the Banks Association of Turkey announced that the Turkish Lira Overnight Reference Rate (TLREF) Committee had completed the benchmark reform to replace the Turkish Lira Interbank Offer Rate (TRLIBOR) and determined the timeline for the transition from TRLIBOR to TLREF. Following this TRLIBOR ceased to be published on June 30th, 2022, the TRLIBOR/TLREF transition spread was announced on July 1st, 2022 and the outstanding TRLIBOR transactions switched to TLREF as of July 1st, 2022.
Refinitiv also announced in November 2022 that it will cease publication of Tokyo Swap Rate for swaps referencing TIBOR on March 31st, 2023.
Given, as highlighted above, focus is currently shifting in the market towards cessation of other IBORs, ISDA published towards the end of last year the November 2022 Benchmark Module to the ISDA 2021 Fallbacks Protocol and accompanying FAQ. The November 2022 Benchmark Module enables parties to include new fallbacks for certain relevant benchmarks (CIBOR, MosPrime, TELBOR) as set out in the Module in their Protocol Covered Documents.
Finally, whilst not discontinuing yet, the search for robust fallback language in EURIBOR contracts has become an increasingly important topic. €STR term rate is expected to be a good alternative. It is worth highlighting that in October 2022, Refinitiv began publishing a prototype forward-looking euro denominated interest rate (the Refinitiv Term €STR). The prototype Refinitiv Term €STR is available daily in 1-week, 1-month, 3-month, 6-month and 12-month tenors. As part of the Working Group on Euro risk-free rates (EUR RFR WG) guidance, forward-looking €STR term rates were recommended as suitable fallbacks for specific EURIBOR-referencing cash products. The introduction of the prototype Refinitiv Term €STR is expected to support market participants as they commence testing in preparation for the introduction of robust fallback language in EURIBOR-referencing contracts.
Also, the European Money Markets Institute (EMMI) launched the so-called Euro Forward-Looking Term Rate (EFTERM) on November 14th, 2022. The new reference interest rate is to be set as part of the EU Benchmark Regulation (EU BMR) and used as a replacement for the EURIBOR if it cannot be determined. The EURIBOR replacement is calculated by ICE Benchmark Administration (IBA) as a calculation agent, with the swap market based on €STR as a basis for the new interest rate.
Going forward, market participants should ensure that all existing agreements successfully transitioned, and they should monitor any further changes and check exposures/assess impact to plan for transition as well as ensure that robust fallback language is in place where possible.
4. REFORMS TO CLEARING MANDATE
Finally, another key trend that we have witnessed over the past months are the proposed reforms to the derivatives clearing mandates. Indeed, the requirement to clear standardized OTC derivatives contracts through central counterparties (CCPs) is aimed at reducing systemic risk via a reduction in the counterparty credit risk associated with the most actively traded contracts. However, in the context of LIBOR transition and the international efforts to migrate to RFR-referencing contracts, not all of the RFR-referencing contracts are included in the current scope of the clearing obligation. This would mean that a large proportion of OTC derivatives activity would no longer be centrally cleared and would therefore undermine the policy objective of the clearing and negatively impact financial stability. It is therefore no surprise that various reforms to the clearing obligation took place.
Notably, in Switzerland, the Swiss Financial Market Supervisory Authority (FINMA) announced in May 2022 the review of FMIO-FINMA to update the catalogue of interest-rate derivatives that must be cleared through a CCP, aligning with the clearing obligation reforms that have already taken place in the EU and in the UK. On December 14th, 2022, FINMA published the partly revised FINMA Financial Market Infrastructure Ordinance (FMIO-FINMA). The ordinance updates the scope of interest-rate derivatives subject to a clearing requirement, in light of the benchmark reforms – the update aligns with the EU’s scope for products subject to the clearing obligation. The partly revised ordinance entered into force on February 1st, 2023.
In the EU, the European Securities and Markets Authority (ESMA) published in July 2022 a consultation on extensions to RFR related clearing obligation and derivatives trading obligation. The proposals contained in the consultation introduce additional classes to the scope of the clearing and derivatives trading obligations. These changes also complement the first set of regulatory technical standards (RTS) that were adopted by the European Commission in February 2022 and published in the Official Journal on 17 May 2022. The first set of RTS removed the EONIA and LIBOR classes, while it introduced overnight index swap (OIS) classes referencing €STR and SOFR to the clearing obligation as well as expanded the maturities in scope for the OIS class referencing SONIA. The second set of RTS included in the consultation introduce the OIS class referencing TONA, expand the maturities in scope of the clearing obligation for the OIS class referencing SOFR, and for the derivatives trading obligation, introduce certain classes of OIS referencing €STR.
On February 1st, 2023 ESMA published its final report on changes to the scope of CO and DTO, following a consultation held last year. The report includes proposed draft RTSs amending the scope of the CO and DTO for OTC interest rate derivatives denominated in EUR, GBP, JPY, and USD. The proposals include for the CO – introduction of the TONA OIS (with maturities up to 30 years) class and extend the SOFR OIS class (up to 50 years); and for the DTO – introduction of certain €STR OIS classes.
Before being published in the Official Journal, the draft RTSs will have to be endorsed by the European Commission and receive non-objection by the Council and European Parliament.
Finally, in the US, the Commodity Futures Trading Commission (CFTC) issued a final rule modifying its clearing requirement for interest rate swaps (IRS) in August 2022. Following this, the final rule updates the types of IRS subject to mandatory clearing by eliminating the requirements to clear IRS referencing LIBOR and other IBORs as well as by introducing, in their place, new requirements to clear IRS referencing the relevant replacement RFRs.
Market participants should therefore continue to closely monitor updates and plan accordingly.
Summary
Market participants must continue to focus on transition efforts and seek to transition the stock of USD LIBOR legacy contracts ahead of June 2023. Further, market participants should also continue to look ahead and increase focus on the cessation of other IBORs as well as take note of ongoing reforms to the clearing mandate in the context of benchmark reform.
Acknowldgments:
Many thanks to Benedict Preti, Rebecca Slade and Viktoriia Pushkar for their valuable contribution to this article.
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